October 18, 2017, 6:29 pm
A stock index-or stock market index-which measures the value of a section of the stock market is computed from the prices of selected stocks (typically a weighted average). Investors and financial managers use stock indices to describe the market, and to compare the relative return on specific investments. Some indices are designed to indicate the broad performance of the overall market, while others follow a much narrower subsector of the market.
Dow Jones Industrial Average
The Dow Jones Industrial Average (Dow) is one of the most closely followed stock market indexes in the world. The Dow was created in 1896 to serve as a proxy for the broader U.S. economy and is the second-oldest stock market index in the U.S., after the Dow Jones Transportation Index. When the Dow first began, it included just 12 companies that were almost purely industrial in nature. As the economy changes over time, so does the make-up of the index. The Dow typically changes when a company is in financial distress and becomes less representative of the economy, or when a broader economic shift occurs. General Electric is the only one of the original Dow components that is still a part of the index.
The Dow currently consists of 30 large-cap blue chip companies, most of which are household names. It is a price-weighted average, which means stocks with higher share prices receive a greater weight in the index. This is different from a market weighted index (S&P and NASDAQ), which weights stocks based on their market capitalization.
The S&P 500 is a stock market index that tracks the 500 most widely held stocks on the New York Stock Exchange. Created in 1957, it is widely regarded as the most accurate gauge of the performance of large-cap American equities. S&P stands for Standard & Poor’s, which are the names of two financial companies that merged. The S&P 500 seeks to represent the entire stock market by reflecting the risk and return of all large-cap companies. Despite the S&P 500’s focus on the large-cap sector of the market, this index is considered representative of the market because it includes a significant portion of the total market value. The 500 companies included in the S&P 500 are selected by committee of analysts and economists at Standard & Poor's. These experts consider various factors when determining the 500 stocks that are included in the index, including market size, liquidity and industry grouping. To be included in the S&P 500, a company must be located in the United States and have a market cap of at least $5.3 billion. At least 50 percent of the corporation's stock must be available to the public and its stock price must be at least $1 per share. Finally, it must have at least four consecutive quarters of positive earnings.
The S&P 500 uses a market capitalization weighting methodology. Market capitalization, or market cap, is the total value of all shares of stock a company has issued. It's calculated by multiplying the number of shares issued by the stock price. The S&P 500 captures 80 percent of the total market cap of the entire stock market.
The makeup of the S&P 500 industries reflects that of the economy. The 2017 sector percentages in the S&P 500 were Information Technology (23.2 percent), Health Care (13.9 percent), Financials (13.7 percent), Consumer Discretionary (12.5 percent), Consumer Staples (9.4 percent), Utilities (3.3 percent), Materials (2.8 percent) and Telecom Services (2.2 percent).
The Nasdaq Composite Index is a market capitalization-weighted index of approximately 3,000 plus common equities listed on the NASDAQ stock exchange. Included in the index are all listed common stocks, American Depositary Receipts, limited partnership interests, real estate investment trusts and tracking stocks. Closed-end funds, convertible debentures, exchange traded funds, preferred stocks, rights, warrants, units and other derivative securities are not included.
As of May 31, 2016, the industry weights of the Nasdaq Composite Index's 2,569 individual securities are as follows: basis materials at 0.46%, consumer goods at 5.89%, consumer services at 20.92%, financials at 8.05%, health care at 13.94%, industrials at 6.35%, oil and gas at 0.64%, technology at 42.49%, telecommunications at 1.15%, and utilities at 0.11%. Because of these weightings, the Nasdaq Composite is a good proxy for technology stocks.
The Nasdaq Composite Index also uses a market capitalization weighting methodology. The index's value equals the total value of the index share weights of each of the index securities multiplied by each security's last price. This total is then divided by an index divisor, which scales the value to a more appropriate figure for reporting purposes. The index is calculated continuously throughout the trading day, but it is reported once per second, with the final confirmed value being reported at 4:16 p.m. each trading day.
The Dow is the most quoted stock market indicator in the world. Although it is also the second oldest U.S. stock market index, it is believed to more accurately represent the broader economy than the oldest market index, the Dow Jones Transportation Index.
Critics complain that the sample of 30 companies in the Dow is too small to serve as an accurate measure of the stock market’s performance. However, the Dow has been measuring the stock market for more than 113 years, which gives it a lot of credibility. Financial professionals consider the S&P a more representative index because it holds about one-tenth of all the publicly traded companies. More importantly, this tenth of the market’s companies collectively represents about 75 percent of the stock market’s total dollar value. Although the NASDAQ has a greater variety of common equities as part of the composite than the other two, it is more heavily weighted toward technology-related stocks.
There is also a difference between the ways the indices are weighted. The Dow is price- weighted and the S&P and NASDAQ are market-weighted. One of the shortfalls of the price-weighted method is that it doesn’t consider the overall size and market value of the company. The capitalization-weighted method will weigh companies based upon the total market value of all their shares i.e. share price times the number of outstanding shares. Price weighting values companies based on their share price, not total market value. As its name says, the Dow is an average. So a company with a share price of $50 makes up five times more of the index than a company with a share price of just $10, even if the lower-priced stock produces twice the profits or has more shares trading in the market.
Despite the differences between these three indices, professional investors closely watch them and these indices move pretty close together. Because the Dow is the oldest and one of the most frequently quoted, it is one of the most widely watched. The S&P500 is watched as a good proxy for the overall market. The NASDAQ is watched but because of its high percentage of technology stocks, it is used more as a technology indicator than anything else. There are also other, more specific indices that professional investors watch, such as indices for bonds, small cap stocks and international stocks.
While this article may concern an area of investing or investment strategy in which we supply advice to clients, this document is not intended to constitute a complete description of our investment services and is for informational purposes only. It is in no way a solicitation or an offer to sell securities or investment advisory services. Any statements regarding market or other financial information is obtained from sources which we and/or our suppliers believe to be reliable, but we do not warrant or guarantee the timeliness or accuracy of this information.
Past performance should not be taken as an indicator or guarantee of future performance, and no representation or warranty, express or implied, is made regarding future performance. As with any investment strategy or portion thereof, there is potential for profit as well as the possibility of loss. The price, value of and income from investments mentioned in this report (if any) can fall as well as rise. To the extent that any financial projections are contained herein, such projections are dependent on the occurrence of future events, which cannot be predicted or assumed; therefore, the actual results achieved during the projection period, if applicable, may vary materially from the projections.
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